Options  |  JUL 2007

Double Diagonals And Butterfly Spreads by John A. Sarkett

Trading With Dan Sheridan (Part 3) Double Diagonals And Butterfly Spreads by John A. Sarkett The third part of this series with trader Dan Sheridan looks at double diagonals with long, protective wings one or more months out from the short options, as well as the butterfly spread, an income-generating strategy. Double diagonals are Dan Sheridan’s single favorite strategy, and he likes to mix double diagonals in a portfolio with condors for diversification. Here’s why: While increasing volatilities hurts the condors, it helps the diagonals. So one offsets the other. Let’s look at double diagonals first. DOUBLE DIAGONALS In addition, the double diagonals strategy has a more favorable risk–reward ratio than other income strategies — 1:2, 1:3, 1:4, compared with 1:10 for condors. The yields can reach 15% to 30% for 30 days on average. Remember, this is a business — “An insurance company without the overhead,” as Sheridan says. Remember, he was a market maker for 22 years. Everything he does is hedged, quantified, managed, and managed in advance, “managed in times of peace, not in times of war,” as he puts it. Best option candidates for double diagonal strategy • Stock is greater than $30 • Implied volatility (IV) in lowest two thirds of its two-year range • Nontrenders, sideways movers • Low volatilities (for nonmovers, we want to go sideways) • Skews (volatilities near and far) in line, not more than four points apart • Nonearnings months — again, we don’t want movement due to news • Boring, sideways, predictable industries, no biotech startups or the like.

by John A. Sarkett